Assume that banks do not hold excess reserves. The banking system has $50 million in reserves and has a reserve requirement of 10 percent. The public holds $20 million in currency. Then the public decides to withdraw $5 million in currency from the banking system. If the Bank of Canada wants to keep the money supply stable by changing the reserve requirement, then what will the new reserve requirement be?
A)10 percent
B)9.1 percent
C)9 percent
D)8.1 percent

Question

Quizplus · Accepted Answer

Initially, banks have $50 million in reserves and the public holds $20 million in currency. Therefore, the total money supply is $70 million ($50 million reserves + $20 million currency in circulation). With a reserve requirement of 10 percent, the required reserves are $7 million ($70 million x 0.10). This means that banks have $43 million in excess reserves ($50 million - $7 million).

When the public withdraws $5 million in currency, the amount of reserves in the banking system decreases to $45 million ($50 million - $5 million). To keep the money supply stable, the Bank of Canada can change the reserve requirement. Let x be the new reserve requirement. Then, the required reserves become $7 million + $5 million = $12 million, and banks must hold $45 million x (x/100) = $12 million in reserves. Solving for x, we get x = 9.1 percent. Therefore, the new reserve requirement should be 9.1 percent.

Assume That Banks Do Not Hold Excess Reserves